New Fed Options Hark Back to Y2K

Among an array of changes the Federal Reserve announced today to ensure liquidity in credit markets was a proposal for options to borrow from the Term Securities Lending Facility that harks back to a similar program used around Y2K.

The new options will allow primary dealers — many of the largest investment banks — to purchase options to borrow at the TSLF at a set rate. It can work as a hedge if rates jump due to stress on the system. The Fed plans only to offer the options “in advance of periods that are typically characterized by elevated stress in financial markets, such as quarter ends,” a statement said.

This gives the Fed an opportunity to get ahead of potential disruptions around known volatile dates. It works primarily to restore confidence among dealers, and, in a best-case scenario, the options may never have to be exercised.

That was the case around the turn of the millennium, when the Fed introduced a similar program, called the Standby Financing Facility. Amid fears of a Y2K bug (that, as we now know, never materialized), market participants suggested that they would curtail their normal trading activities in the federal funds market in the weeks before and after the date change. If such a disruption occurred, it could cause a chain reaction in the federal funds market driving rates well above the Fed’s target rate. To offset this risk, the Fed introduced options that would let primary dealers to borrow under repurchase agreements at a set rate. The thinking was that the mere existence of these options would be enough to keep rates below the strike price as long as the markets’ fears of Y2K technical difficulties didn’t materialize.

The options worked perfectly. Although the Fed took in over $6 billion in premiums from banks that purchased options, they never had to be exercised.

However, there may be more risk involved with this new proposal. Details will be worked out with primary dealers, and won’t be announced until some time next month. Among the issues up for debate are the actual auction dates, expiration dates, and other program terms. There’s no set date — such as Jan. 1, 2001 — this time around. And at the time it was pretty well established when the Fed introduced the options program in 1999 that the Y2K bug was unlikely to cause major problems. In the current environment the Fed’s bet isn’t quite as safe, but the fact that it’s willing to put it’s money on the table indicates that policymakers believe the system is fundamentally sound.

Another issue is the timing of the options strike dates. The Fed only hinted at a timeframe around the end of a quarter. But with such an open calendar, the question remains of when the best time to guarantee rates might be. –Phil Izzo

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